Tuesday, October 30, 2007

Mispriced subprime mortgages hurt everyone*

One of Mr. O'Neal's purported sins was to surprise Merrill's board last month when the size of the company's third-quarter write-down ballooned to $7.9 billion from $4.5 billion. That's a big surprise all right, and it suggests that oversight was late in coming. But it also implies that Merrill did the right thing by taking a good hard look at its books before reporting its results. Some other big banks haven't been so candid. As for Merrill's board, while it may be wielding the ax against Mr. O'Neal, shareholders have a right to ask why those directors were sleeping through 2006.

We suspect some of the tightest white collars these days are over at Citigroup, America's largest bank and one with some of the biggest subprime exposure. Something like $80 billion worth of so-called "structured investment vehicles" sold in Citi's name are wobbling, yet the bank is doing all it can to avoid absorbing those losses on its own balance sheet.

Thus Citi and a few friends have come up with the razzle-dazzle of the $100 billion "super-conduit" fund to buy some of the assets and hope to ride out the storm. We've been wondering why anyone not in similar subprime straits would want to invest in such a fund, notwithstanding Treasury Secretary Hank Paulson's political blessing. (Citigroup director and former Treasury chief Robert Rubin owes Mr. Paulson for that one.) But Citigroup insists the fund is moving ahead, and if they can pull it off, so be it. In any case, the future of Citi CEO Chuck Prince is very much on the line. If he can't find a way to roll over those liabilities in the coming months, the bank may have big write-downs of its own.

This self-cleansing is crucial for the financial credibility of individual companies as they try to win back customers, many of whom have taken a bath. But it is also vital to the larger financial system that the big banks are honest about their mistakes, clean up their balance sheets, and generally police themselves. The short phrase for this is "marking to market." And while it may be painful for companies and CEOs, it will help the system work through the losses faster and prepare for recovery sooner.

And speaking of Washington, that's one place where no one is being held accountable for the subprime boom and bust. That includes in particular the Federal Reserve, whose far too easy monetary policy created a subsidy for debt that fueled the housing and subprime mortgage excesses. One difference between Wall Street and Washington is that in the latter no one ever admits a mistake, much less suffers for it.

*Everyone except Goldman, who was short subprime paper, and politicians who don't need to mark any positions to any market.